A meeting of senior managers at the Pringly Division has been called to discuss the pricing strategy for a new product. Part of the discussion will focus on estimating sales for the new product. Over the past years, a number of new products have failed to meet their sales targets. It appears that the company's profit for the year will be lower than budget and the main reason for this is the disappointing sales of new products.
This time a range of possible sales targes, rather than only one goal will be established and evaluated.
The first strategy is to set a selling price of $170 with annual fixed costs at $20,000,000. A number of managers are in favor of this strategy, as they believe it is important to reduce costs.
The second strategy is to increase spending on advertising and promotions and set a selling price of $200. With the higher selling price the annual fixed costs would increase to $25,000,000. The marketing department are adamant that increased emphasis on advertising and promotions is essential.
The table below shows three probable levels of customer demands. The likelihood of reaching a certain level is indicaated by the estimated probability. Note that it is not necessary to create a complex model based on probabilities. However, the probability distribution provides some guidance for the mangers. Don't forget that the company has certain minimum expectations of a new product.
Estimated demand (units)
Estimated probability (units) *
* Estimated probabilities is to assist in making a final recommendation. These probabilities don't have to be incorporated into a model, just considered in the final recommendation.
The estimate of variable cost per unit is $35.
The probability of the new product achieving break-even is very important. A profit greater than $4,000,000 is expected.
Compute break-even at each level.
Is the company likely to achieve its desired target profit of $4,000,000 or more? Support your discussion with financial analysis.
Compute the margin of safety and explain the meaning of the number derived.
Should the company go ahead with the new product?
Would this type of analysis be useful to a large company with a wide range of products?
ROI (return on investment) and residual income are two other methods that can helpful for this type of decisions. Could they be applied in this situation? Support your answer with financial analysis.
HINT: Don't forget to use the variable costing approach for your analysis.
You should find the breakeven point as follows. The breakeven when the selling price is $170 can be found by first getting the contribution. We get $170 less $35 (variable cost). The contribution is $135. When we divide the fixed costs of $20,000,000 by $135 we get 148,148 units. This is the breakeven point for the price $170.
The breakeven when the selling price is $200 can be found by first getting the contribution. We get $200 less $35 (variable cost). The contribution is $165. When we divide the fixed costs of $25,000,000 by $165 we get 151515 units. This is the breakeven point for the price $200.
You should find the contribution as follows. If the demand is 150,000 and the price is $170, the contribution per unit is $135. The numbers of units that contribute to the profit are 150,000 less 148,148 equals 1,852 units. The contribution to profit is 1,852 units multiplied by $135 equal $250,000.
If the demand is 180,000 and the price is $170, the contribution per unit is $135. The numbers of units that contribute to the profit are 180,000 less 148,148 equals 31,852 units. The contribution to profit is 31,852 units multiplied by $135 equal $4,300,000.
If the demand is 200,000 and the price is $170, the contribution per unit is $135. The numbers of units that contribute to the profit are 200,000 less 148,148 equals 51,852 units. The contribution to profit is 51,852 units multiplied by $135 equal $7,000,000.
If the demand is 150,000 and the price is $200, the contribution per unit is $165. The numbers of units that contribute to the profit are 150,000 less 151,515 equals a ...
This posting gives you a step-by-step explanation of Break-even Point, Margin of Safety, Return on Investment, Residual Point. The response also contains the sources used.